Introduction to Microeconomics

Elasticity and its applications

Quoc Thai Le, Ph.D.*

October 19, 2023
* EFA, International University, VNU-HCM
Materials/Readings

▶ Mankiw, N. G. (2021). Principles of Economics, 9th Edition.

Chapter 5. Boston, MA: Cengage.

▶ https://blackboard.hcmiu.edu.vn/

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Elasticity
Elasticity: what is it?

Crude oil prices account for the majority of gasoline prices. When
crude oil price rises up (for example, in 2022 due to supply cuts),
the price of gasoline soars accordingly.
=⇒ How would gasoline consumers respond to an increase in
gasoline prices (according to the Law of Demand)?
=⇒ How much would gasoline consumers respond to an
increase in gasoline prices?

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Elasticity: what is it?

▶ Elasticity measures the (quantitative/numerical)

sensitivity/responsiveness of one (economic) variable to a
change in another

▶ It tells how much one variable changes when another changes

▶ Elasticity is a ratio of percentage changes in variables

=⇒ What is the difference between elasticity and the slope of

a curve?

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Elasticity of demand
Elasticity of demand

▶ When do consumers usually buy more/less of a

good/service?

=⇒ a qualitative (not quantitative) analysis −→ the direction only

▶ We want to know also the size of the change −→ By how

much do consumers respond to changes in one of key
determinants of demand?
▶ Elasticity (of demand) comes in many forms
the price elasticity of demand
the income elasticity of demand
the cross-price elasticity of demand
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Elasticity of demand

The price elasticity of demand

The price elasticity of demand

▶ The price elasticity of demand measures how much the

quantity demanded of a good/service responds to a change in
its own price =⇒ Intuitively, what does it measure?

▶ The price elasticity of demand for any good/service measures

how willing consumers are to buy more/less of the good as its
price falls/rises.

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The price elasticity of demand

▶ The price elasticity of demand measures the percentage change

in the quantity demanded of a good/service resulting from a
percentage change in the good/service’s price.
%∆ in quantity demanded
▶ Price elasticity of demand =
%∆ in price

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Examples: the price elasticity of demand

Suppose a 10 percent increase in

the price of an ice-cream cone
causes the amount of ice cream
you demand to fall by 15 percent.

−15%
Price elasticity of demand = = −1.5
10%
=⇒ What does a large/small absolute value of the price
elasticity of demand imply?
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Calculation: the price elasticity of demand

Suppose that the demand for a good/service is as follows

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Calculation: the price elasticity of demand

end value − start value

▶ Standard method: %∆ = × 100%
start value
From A to B, %∆ in P =

▶ The standard method gives different answers depending on

where you start
From A to B, elasticity =
From B to A, elasticity =
=⇒ Why?

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Calculation: the price elasticity of demand

end value − start value

▶ Midpoint method: %∆ = × 100%
midpoint
▶ The midpoint is the number halfway between the start and end
values (for example, the average)
▶ It doesn’t matter which value you use as the “start” and which
as the “end” as you get the same answer either way!
From A to B, elasticity =
From B to A, elasticity =

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Exercises: the price elasticity of demand

Calculate the price elasticity of demand for hotel rooms. When

P = 70 then QD = 5000, when P = 90 then QD = 3000.

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Determinants: the price elasticity of demand

▶ The price elasticity of demand varies from good/service to

good/service, depending on:
Availability of close substitutes: as the number of available
substitutes grows, the price elasticity of demand increases =⇒
Why?
Necessities versus luxuries: the price elasticity is higher for
luxuries than for necessities ←− whether a good/service is a
necessity or a luxury depends not on the good/service’s intrinsic
properties but on the buyer’s preferences.
Budget share spent on the good/service: as you spend more of
your budget on a good, the price elasticity of demand increases.
Definition of the market: the price elasticity of demand is higher
for narrowly defined goods than broadly defined ones =⇒ Why?
Time horizon: Price elasticity is higher in the long run than the
short run =⇒ Why?
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Variety of demand curves
▶ Demand curves are classified according to their elasticity
demand is inelastic if the quantity demanded responds only
slightly to changes in the price
demand is elastic if the quantity demanded responds
substantially to changes in the price
=⇒ The threshold for consideration is 1.
▶ Therefore
demand is inelastic if |elasticity| < 1
demand is elastic if |elasticity| > 1
▶ The price elasticity of demand is closely related to the slope of
the demand curve
the steeper the curve passing through a given point, the smaller
the elasticity
the flatter the curve passing through a given point, the bigger
the elasticity
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Variety of demand curves

▶ perfectly inelastic
the demand curve is vertical

▶ inelastic

▶ unit elasticity

▶ elastic

▶ perfectly elastic
the demand curve is horizontal

=⇒ As the elasticity rises, the curve gets flatter and flatter

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Variety of demand curves: perfectly inelastic demand

▶ elasticity = 0 ⇐= Why?

▶ curve: vertical

▶ Consumers’ price sensitivity:

none

=⇒ Examples?

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Variety of demand curves: inelastic demand

▶ |elasticity| < 1 ⇐= Why?

▶ curve: relatively steep

▶ Consumers’ price sensitivity:

relatively low

=⇒ Examples?

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Variety of demand curves: unit elastic demand

▶ |elasticity| = 1 ⇐= Why?

▶ curve: intermediate slope

▶ Consumers’ price sensitivity:

intermediate

=⇒ Examples?

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Variety of demand curves: elastic demand

▶ |elasticity| > 1 ⇐= Why?

▶ curve: relatively flat

▶ Consumers’ price sensitivity:

relatively high

=⇒ Examples?

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Variety of demand curves: perfectly elastic demand

▶ |elasticity| = +∞ ⇐= Why?

▶ curve: horizontal

▶ Consumers’ price sensitivity:

extreme

=⇒ Examples?

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Elasticity and total revenue

▶ TR = P × Q

▶ How does total revenue

change as one moves
along the demand curve?
−→ Elasticity decides!

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Elasticity and total revenue

▶ A price increase/decrease has two effects on total revenue:

higher/lower P means more/less revenue on each unit sold
less/more units sold (due to the Law of Demand)

▶ What is the final outcome?

It depends on the elasticity!

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Elasticity and total revenue: inelastic demand

▶ If demand is inelastic
(|elasticity| < 1)
a increase in P
%∆ in Q < %∆ in P
the fall in T R from lower
Q is proportionately
smaller than the increase
in T R from higher P
T R rises
both P and T R move in
the same direction

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Elasticity and total revenue: elastic demand

▶ If demand is elastic
(|elasticity| > 1)
a increase in P
%∆ in Q > %∆ in P
the fall in T R from lower
Q is proportionately larger
than the increase in T R
from higher P
T R falls
both P and T R move in
opposite directions

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Elasticity along a linear demand curve

▶ The slope of a linear demand curve is constant, but its

elasticity is not.
▶ The slope is the ratio of changes in the two variables, whereas
the elasticity is the ratio of percentage changes in the two
variables.
▶ At points with a low price and high quantity, the demand curve
is inelastic. At points with a high price and low quantity, the
demand curve is elastic.
▶ Elasticity falls (equivalently, demand turns from elastic to
inelastic) as you move downward/rightward along a linear
demand curve.

=⇒ Can elasticity be constant?

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Elasticity along a linear demand curve

In general, elasticities are not con-

stant. They vary as we move along
the demand curve.

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Elasticity along a linear demand curve

P Q TR %∆ in P %∆ in Q |elasticity| description

7 0 0

6 2 12

5 4 20

4 6 24

3 8 24

2 10 20

1 12 12

0 14 0
Notes: The Table illustrates variations in elasticity along a linear
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demand Elasticity 26/51
Exercises: elasticity and expenditure/revenue

▶ Pharmacies raise the price of insulin by 10%. Determine

whether total expenditure on insulin rise or fall?

▶ As a result of a fare war, the price of a luxury cruise falls 20%.

Determine whether luxury cruise companies’ total revenue rise
or fall?

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Elasticity of demand

The income elasticity of demand

The income elasticity of demand

▶ The income elasticity of demand measures the percentage

change in quantity demanded of a good/service due to a
percentage change in the consumer’s income.

▶ The income elasticity of demand informs us of how a change in

income affects the quantity demanded of a good/service.
%∆ in quantity demanded
▶ Income elasticity of demand =
%∆ in income

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The income elasticity of demand

▶ normal goods/services: positive elasticity ⇐= Why?

The income elasticity of demand varies substantially in size.
necessities: small ⇐= Why?
−→ Engel’s Law: as a family’s income rises, the percent of its
income spent on necessities declines, indicating an income
elasticity less than one.
luxuries : large (elasticity > 1) ⇐= Why?

▶ inferior goods/services: negative elasticity ⇐= Why?

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Elasticity of demand

The cross-price elasticity of demand

The cross-price elasticity of demand

▶ The cross-price elasticity of demand is a measurement of the

percentage change in quantity demanded of a good/service due
to a percentage change in another good/service’s price

▶ The cross-price elasticity of demand informs us of how the

quantity demanded of one good/service responds to a change
in the price of another good/service
%∆ in quantity demanded of X
▶ Cross-price elasticity of demand =
%∆ in price of Y

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The cross-price elasticity of demand

▶ substitutes: positive elasticity ⇐= Why?

▶ complements: negative elasticity ⇐= Why?

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Elasticity of supply
The price elasticity of supply

▶ The price elasticity of supply measures how much the quantity

supplied of a good/service responds to a change in its own
price =⇒ Intuitively, what does it measure?

▶ The price elasticity of supply measures the percentage change

in the quantity supplied of a good/service resulting from a
percentage change in the good/service’s price.
%∆ in quantity supplied
▶ Price elasticity of supply =
%∆ in price
▶ The midpoint method is used to compute percentage changes

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Examples: the price elasticity of supply

Suppose an increase in the price of

milk from 2.85 USD to 3.15 USD
per gallon raises the amount that
dairy farmers produce from 9,000
to 11,000 gallons per month.

3.15 − 2.85
3.00 20%
Price elasticity of supply = = =2
11, 000 − 9, 000 10%
10, 000
=⇒ What does a large price elasticity of supply imply?
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Determinants: the price elasticity of supply

▶ Flexibility of sellers to change the amount of the good/service

produced: the more easily sellers can change the quantity they
produce, the greater the price elasticity of supply.

▶ Time period being considered: the price elasticity of supply is

greater in the long run than in the short run ⇐= Why?

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Variety of supply curves
▶ Supply curves are classified according to their elasticity
supply is inelastic if the quantity demanded responds only
slightly to changes in the price
supply is elastic if the quantity supplied responds substantially
to changes in the price
=⇒ The threshold for consideration is 1.
▶ Therefore
supply is inelastic if elasticity < 1
supply is elastic if elasticity > 1
▶ The price elasticity of supply is closely related to the slope of
the supply curve
the steeper the curve passing through a given point, the smaller
the elasticity.
the flatter the curve passing through a given point, the bigger
the elasticity
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Variety of supply curves

▶ perfectly inelastic
the supply curve is vertical

▶ inelastic

▶ unit elasticity

▶ elastic

▶ perfectly elastic
the supply curve is horizontal

=⇒ As the elasticity rises, the curve gets flatter and flatter

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Variety of supply curves: perfectly inelastic supply

▶ elasticity = 0 ⇐= Why?

▶ curve: vertical

▶ Sellers’ price sensitivity: none

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Variety of supply curves: inelastic supply

▶ elasticity < 1 ⇐= Why?

▶ curve: relatively steep

▶ Consumers’ price sensitivity:

relatively low

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Variety of supply curves: unit elastic supply

▶ elasticity = 1 ⇐= Why?

▶ curve: intermediate slope

▶ Consumers’ price sensitivity:

intermediate

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Variety of supply curves: elastic supply

▶ elasticity > 1 ⇐= Why?

▶ curve: relatively flat

▶ Consumers’ price sensitivity:

relatively high

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Variety of supply curves: perfectly elastic supply

▶ elasticity = +∞ ⇐= Why?

▶ curve: horizontal

▶ Consumers’ price sensitivity:

extreme

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Elasticity along a supply curve

▶ The price elasticity of supply varies along the supply curve

▶ Supply often turns from elastic to inelastic as Q rises (due to
production capacity limits).
elasticity is very high at low levels of quantity supplied
elasticity is very low at high levels of quantity supplied

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Exercises: elasticity and changes in equilibrium

The supply of beach-front property is inelastic while the supply of

new cars is elastic.
Suppose population growth causes demand for both goods to
double (at each price, QD doubles).
For which product will P change the most?
For which product will Q change the most?

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Applications
Applications

▶ Can good news for farming be bad news for farmers?

▶ Why did OPEC, the international oil cartel, fail to keep the
price of oil high?

▶ Does drug interdiction increase/decrease drug-related crime?

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Can good news for farming be bad news for farmers?

▶ technology −→ supply shifts

rightward

▶ demand is inelastic ⇐=
Why?

=⇒ %∆ in Q < %∆ in P

=⇒ T R falls

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Why did OPEC fail to keep the price of oil high?

▶ empirics: the (world) price of oil has fluctuated

(risen-then-fallen) substantially throughout 1970s–1980s–1990s

▶ collusion −→ supply shifts leftward ⇐= Why?

▶ in the short run: both supply and demand are relatively

inelastic ⇐= Why?
−→ a large increase in the price
=⇒ %∆ in Q < %∆ in P
=⇒ T R rises

▶ in the long run: both supply and demand are relatively elastic
⇐= Why?
−→ a small increase in the price
=⇒ %∆ in Q > %∆ in P
=⇒ T R falls
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Why did OPEC fail to keep the price of oil high?

▶ OPEC has succeeded in maintaining a high price of oil only in

the short run
▶ Raising prices (to increase profits) is easier to work in the short
run than in the long run.

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Drug interdiction versus drug-related crime

▶ Illegal drug use has several adverse effects on society.

−→ Drug addicts often turn to crime to finance their habit.

▶ Demand for illegal drugs is inelastic due to addiction issues

▶ How to discourage the use of illegal drugs is an important

research question −→ two solutions
the supply side ←− drug interdiction
the demand side ←− drug education

▶ Assumption: the total monetary value of drug-related crime

equals total expenditure on drugs

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Drug interdiction versus drug-related crime: interdiction

▶ demand is inelastic

▶ interdiction −→ supply shifts

leftward
−→ only drug use (Q) reduces

=⇒ %∆ in Q < %∆ in P

=⇒ T R rises (even though the

amount of drug use falls)

=⇒ the amount paid by drug

users increases −→
drug-related crime increases

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Drug interdiction versus drug-related crime: education

▶ demand is inelastic

▶ education −→ demand shifts

leftward

=⇒ both P and Q fall

=⇒ T R falls

=⇒ a decrease in the amount of

drug use, in total spending
on drugs and in drug-related
crime

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 Q&A

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